Wednesday, October 12, 2016

The outlook hasn't changed much this month, and I've been doing some traveling (this week I'm in Park City to attend a Cato conference), so that explains the lack of posts. What follows are some updated charts and commentary:

The September payroll report was consistent with what I've been saying in recent months: jobs growth has downshifted, from a 2% annual pace to now 1.7% or so. That's not a huge deal, but I think it reflects the uncertainty surrounding the elections and the eventual policy outcome. Those with investment decisions to make on the margin are most likely to hold off until next year before deciding to move ahead with new investment/expansion/hiring plans. We therefore are unlikely to see any meaningful improvement in the economy this year.

Jobs growth is slowing, but the growth of the labor force is picking up. More and more people are deciding they would prefer to work than to sit on the sidelines. The gap between the two lines in the above chart suggests that there are as many as 10 million people potentially available to re-enter the workforce.

There is a similar gap between the current size of the economy and its potential size, as the chart above shows. That gap is now equivalent to about $3 trillion in "lost" income per year. In other words, there is tremendous untapped potential in the U.S. economy. That potential could be tapped if policies become more growth-friendly (e.g., lower tax rates, reduced regulatory burdens). That's what this election should be about, but the degree of acrimony that exists between the two parties and their candidates is an unfortunate distraction. I wish I knew how it will all play out.

The unemployment rate has stopped declining and looks set to increase a bit in coming months. Traditionally, a rising unemployment rate only happens as the economy slides into a recession. Things are very different this time around, however. The unemployment rate is moving higher not because more and more people are getting laid off, but because more and more people are deciding they'd rather work than sit on the sidelines. This is arguably the first time this has happened in modern times. Don't be worried, therefore, by a rising unemployment rate—it doesn't mean what it used to mean.

In the currency market, the big news is the abrupt decline of the pound. According to my PPP analysis, the pound is now "cheap" relative to the dollar, for the first time in more than a decade. Time to make plans to visit the U.K.! The most likely cause of the pound's weakness is the U.K.'s decision to exit the European Union. There are lots of things in play, and thus the outcome is fraught with uncertainty. In the long run I think a Brexit is good for the U.K. (since it will free up markets), but in the near term the uncertainty is not surprisingly bad for markets.

The U.S. stock market is more nervous these days, as indicated by the Vix index in recent months rising from a low of 11.3 to now about 16. But the Vix/10-yr ratio hasn't increased much at all, because 10-yr yields have risen from a low of 1.36% to now about 1.8%. Investors are more nervous, but yields are rising because there is less pessimism surrounding the outlook for growth. As a result, the stock market has been relatively stable.

The Fed is on the minds of nearly everyone these days, but I don't see major problems ahead. The chart above tells us that the market only expects a very modest rise in real short-term interest rates in coming years. (That's the message of the blue line in the chart above.) And that makes sense given the sluggish economy and the relatively low and stable rate of inflation. Things could change in the future, of course, but interest rates are likely to surprise on the upside only if the economy strengthens meaningfully and/or inflation rises.

It's important to keep in mind that there are two ways the Fed can "tighten" monetary policy: 1) they can take steps that result in an increase in the nominal Fed funds rate, and/or 2) they can take steps that result in an increase in the real Fed funds rate. It's the change in the real Fed funds rate that is the most important, since that affects real borrowing costs (and real returns on savings) for everyone. Traditionally, the Fed has increased the nominal funds rate by draining bank reserves, which the Fed accomplishes by selling bonds that it owns. Prior to late 2008, any reduction in the supply of bank reserves would force banks to curtail their lending, since banks had a strong incentive to avoid holding excess reserves. With a shortage of reserves, banks were forced to pay up to borrow needed reserves (needed to collateralize their deposits), and that is what caused short-term interest rates to rise.

Since 2008 that has all changed, for the first time ever. Today there are over $2 trillion in excess reserves in the banking system. As a practical matter, the Fed can't possibly drain enough reserves on the margin to cause a shortage of reserves. Instead, in order to push short-term rates higher all the Fed has to do today is declare that it will pay more interest on the reserves held by the banking system.

So as the current "tightening" cycle proceeds, the banking system will almost certainly not experience any shortage of reserves or any shortage of essential liquidity. Today, higher short-term rates will mean only that borrowing costs increase marginally and the rewards to savings increases marginally. It's more of a zero-sum game now, whereas "tightening" in prior cycles meant the banking system was being squeezed and money and liquidity were becoming scarce. Of course, we've never experienced a tightening cycle under the current IOER regime, so it's impossible to predict how things will play out. But it is safe to say that this time things will be different. The Fed won't really be tightening in the sense of limiting bank liquidity; rather, it will acting directly to raise the level of short-term interest rates. A quarter-point increase in short-term borrowing costs and a similar increase in the interest rate paid on bank savings deposits and money market funds is not likely to create more than a minor ripple in the U.S. economy. Lots of people (e.g. savers) will likely cheer, while few (borrowers) will grumble. As long as liquidity is plentiful, the banking system and the financial markets will be able to play the role of "financial shock-absorber," and that in turn will mitigate the risk of recession.

In the chart above we see that the prices of 5-yr TIPS and gold have been flat to down in recent months. This suggests that the market's demand for safe-have assets has stabilized or declined, and that further suggests that the general level of uncertainty has improved a bit. Nothing wrong here.

UPDATE: Here is a chart of excess reserves (reserves held by banks that are not needed to collateralize deposits). Excess reserves have declined in line with a decline in total reserves; apparently the Fed is slowly (and quietly) unwinding some of its QE efforts. But there are still plenty of reserves out there.

As I've argued for years, monetary policy these days all revolves around the demand for money (http://scottgrannis.blogspot.com/2015/06/the-feds-game-plan-its-all-about-demand.html). Without the ability to restrict the supply of reserves, the Fed needs to instead raise interest rates directly. If they do things right, higher rates will increase the attractiveness of "money," thus encouraging banks to hold on to the excess reserves they have. In other words, raising rates should increase the demand for money, offsetting any decline in the demand for money that results from a stronger economy and/or increased optimism about the future.

It's certainly possible that the Fed could underestimate the degree to which they need to raise rates, but it's impossible to know at this point how things will play out. We will all be "playing it by ear."

Reverse repos are one increasingly important way in which the Fed can "drain" reserves from the banking system. The Fed has been experimenting with reverse repos for some time now, as the graph illustrates. The increase in reverse repos shown in the graph is of about the same magnitude as the decline in excess reserves shown in my graph. So it would appear that the Fed has been quietly removing reserves from the banking system via reverse repos. Here is the NY Fed's descriptions of how repos and reverse repos work:

Scott, off-topic but: do you have a view on whether Hilary Clinton and potentially a Democrat-dominated Congress will be very bad news for the pharma and biotech industries ? Stocks have been hit already several times because of her threats to intervene and reduce drug pricing. Thanks.

If the Dems controlled the presidency and the Congress, the chances of price controls and/or single payer would rise enormously. I don't think there's an easy "fix" for Obamacare, so fundamental change would be required. I'd vote for free market reforms, but the Dems would be very unlikely to favor that option, unfortunately.

I am not sure why the Fed wants to drain reserves from the commercial banking system. Some people say the Fed is trying push-up short-term T-bill rates towards 0.50%, and that is the reason for the heavy reverse-repo action. it creates selling pressure, and short-term Treasury sellers must offer greater interest to win buyers.

There is global demand for U.S. Treasuries, of course. The Fed may be fighting the tide.

Clearly, the Fed is now paying banks more on reserves than banks can earn on short-term Treasuries.

I do think another rate hike, which seems always to come in 0.25% chunks (never 0.10% for example), will raise the prospects of banks making money by doing nothing.

Another federal program started under the best of intentions that ends up as a permanent subsidy for one or another group?

And how much upside in raising IOER can there be? Back in the 1980s I worked in the S&L industry. The bosses talked about needing a 200-basis point spread to make money, between deposits and mortgages.

Benjamin: Very wise words from you. The spread between short term treasuries and the IOER supports my thesis that the Fed is chronically too tight, modestly. Certainly this is true relative to its 2% inflation goal. Five and ten year TIPS spreads confirm this (and have for a very long time).

Matthew: Yes, I think the Fed and other major global central banks have been tight, and since 1982 or so, and this is seen in secular global trends to lower inflation and lower interest rates, and now deflation and negative interest rates in much of the developed world.

If the 35-year global trend to lower inflation and then deflation is not the result of tight money, then we might as well toss all the monetary policy books out of the window!

The central banks won the war on inflation….but they can't seem to stop fighting the war, and have ossified into position. There is also the conflating of historically low nominal rates with being "accommodative."

However, public agencies frequently become stagnant, even as they become self-reverent. In the past decades the Fed has built up enormous economics staffs at HQ and in the regional branches. This is not an organization that can criticize itself for chronic tightness, or accept blame for 2008.

In fact, among central bankers a type of theomonetarism has evolved, and many say they have only an obligation to dead zero inflation---as dubiously measured, and whether or not dead zero is the best inflation rate for robust economic growth.

Needless to say, central bankers are not real estate developers or business guys with a stake in economic growth. If there is a place on earth more Ivory Tower than a central bank (a bubble world, safe from the economy) I do not what what it is.

On fiscal policy, I am a balanced budget kind of guy, although Scott Grannis and others have expressed a need for a few hundred billion a year of fresh Treasury bills to serve financial markets. I think we can balance the federal budget and markets can adapt, but obviously this is complicated topic.

He elaborated on a speech he gave on Friday at the start of a conference on the economy at his regional bank when he said “if one were concerned about the historically low 10-year Treasury rates.....the balance sheet composition could be adjusted to steepen the yield curve.”

Remember, I suggested 2 months ago that it was time for Central Banks to sell longer dated bonds to steepen their yield curves in order to support their bank earnings. This is particular pertinent in the Euroland and Japan.

Textbooks have historically hypothesized that government expenditures lift economic growth by some multiple of every dollar spent through a positive government expenditure multiplier. As such, deficit spending has long been considered to be a positive for economic expansion. If the expansion lasts long and generates faster actual and expected inflation, bond yields should rise via Irving Fisher’s equation (Theory of Interest, 1930).

Impressive scholarly research has demonstrated that the government spending multiplier is in fact negative, meaning that a dollar of deficit spending slows economic output. The fundamental rationale is that the government has to withdraw funds, via taxes or borrowing, from the private sector, to spend their dollars."

The Real Truth

"Decelerating Economic Growth

From a fiscal and Keynesian perspective, 2016 should have been a year of accelerating economic activity. There was no crisis in passing the 2016 budget. There was a nonpartisan deal to accelerate military and civilian spending as well as a deal to hike outlays for highways. The increased expenditures and debt were going to occur after two years of slower growth in nominal GDP, which according to its advocates meant that the timing was right. Nevertheless, the economy sputtered. This once again confirms the existence of a negative government spending multiplier.

A $1.4 trillion jump in federal debt was paired with both weaker economic growth and falling treasury yields. Unfortunately, the 2017 economic horizon is clouded by the rising likelihood of further increases in government spending and debt. The inevitable result will be slower economic growth and declining interest rates, a pattern similar to the 2016 experience."